A Novel Pricing Method for European Options Based on Fourier-Cosine Series Expansions

Abstract

Here we develop an option pricing method for European options based on the Fourier-cosine series and call it the COS method. The key insight is in the close relation of the characteristic function with the series coefficients of the Fourier-cosine expansion of the density function. In most cases, the convergence rate of the COS method is exponential and the computational complexity is linear. Its range of application covers underlying asset processes for which the characteristic function is known and various types of option contracts. We will present the method and its applications in two separate parts. The first one is this paper, where we deal with European options in particular. In a follow-up paper we will present its application to options with early-exercise features.